Equity PM Flashcards
Name and explain the 4 reasons for having equities in a portfolio
Capital Appreciation
Dividends
Diversification
Hedge against inflation
Diversification because the correlation between equities and other asset classes should be less than 1.
What happens to diversification during times of financial crisis?
Correlation moves closer to 1, removing the positive effect of diversification
Name and explain the 3 portfolio constraints one can impose on a portfolio
Negative screening - only invest in x industries
Positive screening - only invest in best in class
Thematic Investing - only invest in a theme
Name the 3 ways to segment a portfolio
Size/Style
Geography
Economic Activity/Sector
What is an advantage of segmenting a portfolio by Size/Style
To match a portfolio to an appropriate benchmark
For diversification benefits
To highlight how the style of a portfolio has changed over time
What is advantageous and disadvantagoues about a geography segmentation strategy
Good: Allows diversification across geographies
Bad: Currency risk, interconnection between economies means there may not be a huge diversification benefit
What are the 2 types of economic/sector segmentation strategies
Market based - a company will be classified as the market determines (luxury cars will be a consumer discretionary)
Production based: A company will be classified by what it produces (luxury cars being an industrial)
Name the Fees in an equity portfolio
Management, Performance, Administrative, Marketing/Distribution, Investment Strategy, Trading costs
What is shareholder engagement
Shareholders getting involved in their investees business to try to further their prospects. THey try to push ESG considerations and align interests of managers with that of shareholders
What are the issues with shareholder engagement
Potential dissemination of material nonpublic information
Larger investors backing thier own interests
The short term focus of active shareholders
What are the types of income in an equity portfolio
Dividends, Security lending, Writing options, dividends option selling
What is security lending?
Lending the stock to another party for them to participate in short selling. You give up your right to vote on the equity, but keep your dividend rights
Why might security lending be bad?
You have to assess the credit quality of the lendee
If heaps of people are short selling the stock in question, it is going to push down the value of your position, dont let them lend your stock
Under what circumstance would a covered call make money for a portfolio
Covered call is when you have an equity, and you WRITE an option on it - so you would make money when the stock price does NOT exceed the exercise price - you get that premium
What are the good and bad things about active investing or choosing to go with an active manager
Superior knowledge, client preference, needed for mandate
Tax, turnover of portfolio, key person risk, potential unethical behaviour of managers
Benchmarks must be 3 things, what are they?
Rules based (market cap, price based, rebalance daily, yearly?)
Transparent
Investable
What are the considerations when choosing an index for a passive fund?
Market exposure - what are you trying to get exposure to? SP 500? Small caps? Pick one that is appropriate
Understanding the rules of the benchmark
Price based, market cap based
Explain a market cap based index and what is a disadv
So like, if you got an index of like 1trillion in market cap, and one security makes up like 600 million, that stock would be 60% of the index/benchmark.
Disadv: Large Cap dominant
Explain equal weighted index an a disadv
100 stocks in index = 1% per stock. Same dollar value in each.
High turnover though, and small cap stocks will dominate returns
What is a fundamental index
Basing an index off like sales or other financial reporting items
Why would you use the HHI in passive investing
It is used to determine if you can use a reduced number of stocks in an equal weighted portfolio to match the risk characteristics of a market cap based portfolio
What is factor based (smart beta) portfolios
Portfolios with exposure to a certain risk characteristic, like momentum, duration, volatility.
This implies active decision making by the PM tho.
Pros and cons of active factor based portfolios
Less costly than active portfolios.
Higher trading commissions than market cap based
What are the 3 approaches to passive equity investing (how can you do it)
Pooled investments (ETFs, Mutual funds)
Derivatives
SMA
Adv and Dis adv of pooled investments into passive investments
Mutual funds are cheap, liquid, easy, but can have taxable events that impact the underlying investor
Etfs are more liquid than Mutual funds, giving intraday liquidity, but do have commissions and buy sell spreads
Explain using derivatives to get exposure to passive equity indexs
Using OVERLAYS to adjust a portfolio to that which matches a passive equity portfolio
Completion Overlay: Using excess cash to move beta (or some other risk) back in line with what the index is
Currency Overlay: Reduce currency exposure
Rebalancing Overlay: Synthetically generating exposure to a certain stock, or contrary, after reconstitution of index
Whjat is Basis risk in a passive equity portfolio (derivatives)
The risk that when using a futures contract to artifically change the exposures of a portfolio, that the future value is not equal to the spot price of the stock in question, meaning there could be a loss.
The future price and stock price SHOULD go up in unison
Advs of derivatives in equity passive portfolios
Cheap, easy, accessible, access to leverage
What are the 3 ways to CONSTRUCT a passive equity portfolio?
Full replication
Optimization
Stratified Sampling
Discuss Full replication in passive equity portfolio construction
It is basically taking all the positions in an index, and replicating it.
Can be hard to integrate, but will have the lowest tracking error (good).
There will be more trading costs and there may be issue in getting exposure to lower liquidity. positions AND there will be cash drag
Discuss Stratified sampling in passive equity portfolio construction
It is basically working out the risk factors that an index is exposed to (momentum, size, geography) assigning each of those a weight based on how they are represented in the index - then creating an index allocating stocks from, or outside, the index to each of those factors.
Great to avoid a heap of trading costs, can use stocks outside the index, and the more factors you have, the lower the tracking error
Discuss Optimisation in passive equity portfolio construction
This is using a computer to work out the HISTORIC lowest tracking error stocks in an index, then just using them to create a portfolio.
This uses historic positions, which is bad for predicting the future.
THis is also hectic because it takes interstock correlations into consideration
Name the things that can increase tracking error
Management fees
Trading costs
Buy sell implicit cost
Cash drag
What is cash drag
When you have cash in the portfolio that does NOT have a position in the index that you are trying to replicate. Causes a drag on performance
Explain a price weighted vs equal weighted index
Price weighted = # of stocks is equal for each position in the portfolio
Equal weighted = same $ amount invested in each position in the portfolio
Discuss some key differences between fundamental analysts and quantatative analysts
Fundamental = Higher conviction, less positions, more subjective, uses financial statements
Quant = uses hefty amount of data, more positions, less conviction, identified relationships between variables to predict future performance
Value Investing - explain special situations, deep value, relative value, income based and distressed
Special situations is for taking advantage of corporate actions that may more stock price
Deep value is for stocks the have incredibly low P/B and informational inefficiencies may be present in the market due to lack of interest (GME)
Relative = low P/B vs index
Distressed = about to go out of business
Explain factors that would be present in a growth company
High P/B, P/E. Growing EPS. High revenue growth. High ROE etc.
How would you take advantage of high vol in the market using derivatives
straddle. Buy calls and puts at the money
Hard one - how would you increase the risk exposure of a portfolio from an index currently exposed to 3 factors?
You would REDUCE the factors you are exposed to. Like the passive equity portfolio construction, when you have more factors, the tracking error goes down. When you have fewer factors, the risk exposure goes up.
What if you were exposed to style, size and momentum, then you just changed to size, and size is suddenly out of favour? Then you are screwed
Identify 3 factors
Size, growth, momentum, value
Explain the hedged portfolio approach
it is getting your investable universe of growth stocks (for example), then ranking all those stocks into quartiles. Longing the top quartile and shorting the bottom quartile
What are some disadvantages of the Hedged Portfolio approach
It doesn’t use info from the middle quartiles
Assumes linear relationship between factor and stock returns
Assumes shorting is possible
What is factor timing
Jumping from factor to factor based on when one is going out of favour and into favour
Shareholder activism, what are some things they do to get thier point across
Get spots on the board Speak at AGMs Open letters to management Rally support from other shareholders Reduce management compensation
What are some defenses to shareholder activism
Staggered boards (only some of the board is reelected each year)
Poison pill - issue more shares to dilute activist position
Multiclass share
Limit voting rights on new shareholders
Explain an example statistical arbitrage strategy
Pairs trading. 2 heavily correlated stocks, buying the undervalued and shorting the overvalued
Explain process of fundamental active strategies
Define universe based on mandate Pick stocks to further analyze Predict cash flow Value based on cash flow Implement into portfolio Rebalance
What are some examples of pitfalls active managers fall into
Behavioral biases (overconfidence, control illusion etc)
Value trap
Growth trap
What is the value trap
Buying into a stock thinking that it is undervalued, when in fact the value continues to decline, the entry point is where the stock was still overvalued
What exactly is a quant strategy?
A quant strategy is one that uses rule based investing to manage the portfolio for you. It uses a variety of data sources ranging from financial statements to unstructured credit card info to even images.
What are the steps in quant investing?
Define mandate Acquiring the data you need (images, credit card data, financial statements) Backtesting strategy Evaluating it Implementing strategy
What are the 2 Information coefficients you use to determine if a quant strategy is good?
Pearson and Spearman.
Spearmen is better because it disregards outliers
What are some pitfalls of quant management
Trading costs Avalaibility of short selling Look ahead bias (knowing something you shouldn't) Survivorship bias Quant overcrowding
What are the 2 types of style analysis - and which is better
Return based and holding based
Holding based is better
Explain return based analysis - and the formula
Return(P)=α+β1index1+β2index2+β3index3+ϵ
So, you run a regression of the return of the portfolio you are evaluating against that of various indexes that are mutually exclusive with NO crossover. This will give you a regression coefficient.
The will help you determine if one index dominates the return of the portfolio.
You can also subtract 1 from the R^2 to determine the stock selection return
Holdings based return style analysis - explain
Pretty much bottom up analysis of each position in a portfolio to work out if the position is in fact a value or growth stock
When using style analysis to undertsnad a portfolio - why might using a holdings based OR return based analysis be no good
It is always done using historic data - the positions in the portfolio may have changed.
You should also do it across MULTIPLE periods for accuracy
Hard to mark derivates into a style
Hard to evaluate more aggressive styles (deep value) into the constrained categories
WHat are rewarding and unrewarding factors
Rewarding factors are the normal factors like value, growth and momentum, while unrewarding factors are sector and stock specific allocations
Identify the 3 sources of active return
Factor exposure
Alpha (specific risk)
Idiosyncratic risk (luck)
Name and discuss the 3 building blocks of an active portfolio
- Factor Weighting - overweight or underweight a rewarded factor
- Alpha - stock, sector (unrewarded) factor allocation
- Sizing - big position or small position. Also the amount of positions
What does including more positions do to your idiosyncratic risk
Lowers
What does cash do to your active risk and why?
Cash will INCREASE your active risk. Why? Because it has a LOW covariance with the BM even if it has low SD.
Explain active share
It is how similar your positions are to the benchmark - and how overweight/underweight your positions are.
An active share of 1 means that your positions are very different from the BM, you either hold all overwieght and underweight positions, or different positions all together
1-Active share is your overlap with the BM
If your active share goes up, what happens to your active risk?
Depends. It does not always mean that it goes up.
If you overweight then underweight 2 positions in a correlated sector - like oil or something - your active share will increase, but your active risk may not.
If you have 2 portfolios, both with active share of 30% and 2 different active risks - what could explain this?
That the portfolio with higher active risk has more active bets on sectors or cash positions - but their active positions on individual securities remain the same
if you decrease your exposure across factors (go from exposure to 10 factors to 2) what happens to risk
Increases
Steps in risk management/budgetting
Determine appropriate risk measure (absolute/relative)
Determine where the risk will come from
Determine risk target
Allocate risk
Explain contribution to variance in a portfolio
It is the weight of each security times its covariance of the asset to the portfolio - then sum each up.
So if you have 3 securities in a portfolio, each 33%, and the risk of each is 10, 20 and 30% , the total variance would be 3+6+9
Explain a market neutral equitized strategy
Basically pairs trading in each sector until the beta of the portfolio is 0, then going long an index using a future contract to regain market exposure
Advantages of Long Only Strategy
Generally more liquid than long short Less admin, fees Not as much regulatory burden More transparency to investors Less risk
Advantages of long short Strategies
Reduce market risk (ability to SHORT an overpriced stock)
Diversifcation
Controls risk exposure
Disadv of long short strategies
Unlimited risk
Increased leverage
Costs/implementation costs
Potential for a short squeeze
On a long short strategy, how do you generate returns (2)
Alpha from the trade
INTEREST on reinvested cash from the short
Are long or short positions more likely to generate alpha and why
Short - with the burden and admin of short selling, these securities are more likely to be mispriced
How would you gain exposure to large cap mispricing in equities and the small cap market
This is wanting to generate alpha from stock selection at the large cap, and market return on the short cap
Long cap = long short strategy
Short cap = long russell 2000
